Final Regulations Issued to Property Transferred in Connection With the Performance of Services Under Section 83 of the Internal Revenue Code

Section 83 of the Internal Revenue Code (“IRC”) controls the tax treatment of restricted property, including restricted stock, some forms of stock options, and other types of deferred compensation, issued in connection with the performance of, or the refraining from performance of, services.[1] As a general rule, section 83 requires a person (which is not necessarily a natural person) performing services to include in income the amount that the fair market value of the property received exceeds the amount paid for the property once the property is “substantially vested.” That is, a person generally does not report income until the earlier of the time when the person can transfer his rights to the property or no longer has a substantial risk of forfeiting the property, unless the person makes a “Section 83(b) election.”

On February 26, 2014, the Department of the Treasury (the “Treasury”) issued final regulations, effective on that date and applicable to property transferred on or after January 1, 2013 (the “Final Regulations”).[2] The Final Regulations make several clarifications with respect to whether a substantial risk of forfeiture exists to property covered by section 83 by revising paragraph (c)(1) of section 1.83-3 of the Treasury Regulations.[3] First, the Final Regulations clarify that generally the only way to establish a substantial risk of forfeiture is through a service condition or a condition linked to the purpose of the transfer.[4] Second, the Final Regulations make clear that the Internal Revenue Service (the “IRS”) will consider two factors when determining whether a substantial risk of forfeiture occurs in the context of section 83(b): (x) the likelihood of the occurrence of the forfeiture event and (y) the likelihood of enforcement of the forfeiture.[5] Third, the Final Regulations make plain that transfer restrictions generally do not create a substantial risk of forfeiture if the restrictions are violated.[6] According to the summary provided in the Federal Register, the Treasury and the IRS believe that the clarification of the definition of a substantial risk of forfeiture does not narrow the requirements to establish a substantial risk of forfeiture and that the revision to the definition of substantial risk of forfeiture is consistent with the interpretation that the IRS has historically enforced.[7]

In the summary of the comments provided in the Final Regulations, the Treasury and the IRS note that what qualifies as a substantial risk of forfeiture under section 409A of the IRC, which covers nonqualified deferred compensation plans, may differ from what qualifies as a substantial risk of forfeiture under section 83.[8] For purposes of section 409A, a service provider’s right to receive property (or an amount in cash) in the future upon a service provider’s involuntary separation from service without cause may be subject to a substantial risk of forfeiture so long as a substantial possibility of forfeiture exists.[9] For purposes of section 83, however, a substantial risk of forfeiture can generally occur under only one condition: when property is actually transferred in relation to the performance of services.[10] An involuntary separation from service that occurs without cause does not constitute a substantial risk of forfeiture under section 83 if no property is transferred until after the separation of service because a right to receive property in the future is generally not considered property for purposes of section 83.[11]

The summary of comments also notes that in the event that a transfer of property does occur, two ways exist to establish a substantial risk of forfeiture.[12] One way is by having a substantial services condition.[13] The other way is by imposing a condition related to the reason for the transfer if the possibility of forfeiture is substantial.[14] Merely because vesting accelerates when an involuntary separation of service occurs without cause does not entail that the requirement of substantial services that would otherwise qualify as a substantial risk of forfeiture will fail to qualify as such, so long as facts and circumstances do not establish the likelihood that involuntary separation from service without cause will occur during the service period. [15] The Final Regulations also revise Example 4 of the proposed regulation section 1.83-3(j)(2), which sets forth a situation when property is considered subject to a substantial risk of forfeiture because of a transfer restriction under section 16(b) of the Securities Exchange Act of 1934, which imposes certain trading restrictions on officers, directors, and beneficial owners of more than 10 percent of any class of non-exempted equity securities of companies whose securities are registered on a national securities exchange in order to prevent the unfair use of inside information.[16]

Revised paragraph (c)(1) of section 1.83-3 adds the qualification that, except as set forth in paragraphs (j) and (k) of that section, which pertain, respectively, to sales that may give rise to suit under section 16(b) of the Exchange Act of 1934 and to special rules for certain accounting rules, a substantial risk of forfeiture exists only if rights in property that are transferred are conditioned, directly or indirectly, (a) upon the future performance (or refraining from performance) of substantial services by any person, or (b) upon the occurrence of a condition related to a purpose of the transfer if the possibility of forfeiture is substantial.[17] Previously, paragraph (c)(1) stated that a substantial risk of forfeiture exists where rights in property that are transferred are conditioned, directly or indirectly, upon (x) the future performance (or refraining from performance) of substantial services by any person, or (y) the occurrence of a condition related to a purpose of the transfer, and (z) the possibility of forfeiture is substantial if such condition is not satisfied. [18] The revision also adds the following sentence: “Property is not transferred subject to a substantial risk of forfeiture if at the time of transfer the facts and circumstances demonstrate that the forfeiture condition is unlikely to be enforced.”[19] Moreover, the revised text also adds the following two sentences to the end of the paragraph: “A restriction on the transfer of property, whether contractual or by operation of applicable law, will result in a substantial risk of forfeiture only if and to the extent that the restriction is described in paragraph (j) or (k) of this section. For this purpose, transfer restrictions that will not result in a substantial risk of forfeiture include, but are not limited to, restrictions that if violated, whether by transfer or attempted transfer of the property, would result in the forfeiture of some or all of the property, or liability by the employee for any damages, penalties, fees, or other amount.”[20]

Revised paragraph (c)(4) of section 1.83-3 adds two new examples, six and seven. Example six shows that under the facts presented, neither section 83(c) nor the imposition of the lock-up period by an underwriting agreement entered into in connection with an initial public offering precludes taxation under section 83 when the shares resulting from exercise of the option are transferred. Example seven illustrates that neither the insider trading compliance program described in the example nor the potential liability under Rule 10b-5 of the Securities Act of 1934 under the facts presented in the example imposes a substantial risk of forfeiture because the provisions of the program and Rule 10b-5 do not condition the recipient’s rights in the shares (x) upon anyone’s future performance (or refraining from future performance) of substantial services or (y) on the occurrence of a condition related to the purpose of the transfer of shares to the recipient.[21] Thus, these two examples provide two factual scenarios in which contractual and legal restrictions do not create a substantial risk of forfeiture.

Revised paragraph (j)(2) of section 1.83-3 adds a new example, example four.[22] This example provides three separate factual scenarios, two of which demonstrate that purchases of shares in a transaction not exempt from section 16(b) of the Securities Exchange Act prior to the exercise of a stock option that would not otherwise give rise to section 16(b) liability does not defer taxation of the stock option exercise, and one of which shows that the exercise of non-statutory options during a period where a transfer restriction under section 16(b) exists does make the property subject to a substantial risk of forfeiture.[23]